Wednesday, August 20, 2014

Since all the evidence to date suggests that the economy continues to improve on the margin, the FOMC (in their statement released today) is right to think that they may have to raise short-term interest rates sooner than expected. The market agrees, and that makes higher-interest-rates-sooner-than-expected virtually certain. At this point, I'm guessing that the FOMC will begin to raise rates no later than March of next year. However, at the rate things are improving, there is no reason they couldn't begin to "lift off" sooner than the end of this year.

This amounts to a triple dose of good news for investors: 1) the economy is definitely improving, 2) short-term interest rates are going to rise to more attractive and reasonable levels within the foreseeable future, and 3) all of this should serve to boost optimism and reduce uncertainty about the economy's prospects.

Here are some charts updated for recent announcements that are also germane to investors' decisions going forward.

The outlook for commercial real estate looks solid, as I noted earlier this week, and the July housing starts and recent survey of builder sentiment (see graph above) released today point to continued improvement—albeit relatively modest—in the residential market.

Architectural billings in July suggest that the outlook for commercial construction activity is positive and improving.

Nominal GDP has been growing at about a 4% pace for most of the past four years, yet the Fed has kept short-term rates extremely low. This is unsustainable. The sooner the Fed gets short-term rates back to levels consistent with 4% nominal GDP growth, the better. As the chart demonstrates, there is no reason to think that higher interest rates are detrimental to growth. Higher interest rates are instead a logical consequence of growth.

The CPI has increased at about a 2.3% annualized pace for more than 10 years. At this rate, prices increase by over 25% every decade. That's not insignificant, and it's not even close to deflation. It's not healthy either. In fact, it transfers hundreds of billions of dollars from the private sector to the federal government every year. How? The interest rate on cash, savings deposits, T-bills, bank reserves, and other short-term instruments is about 2% lower than the inflation rate. That means that holders of cash and short-term securities are losing 2% of their purchasing power every year, and the federal government and the Fed (which transfers any and all profits on its balance sheet holdings to the Treasury) are the direct beneficiaries.

It makes little or no sense for the Fed to continue to keep real short-term interest rates in deeply negative territory. It's potentially quite destabilizing, since it encourages excessive borrowing and leveraging and speculative activity. Eventually it could become a potent source of higher inflation, since negative real interest rates undermine the demand for money at a time when the Fed is still eager to supply it, and that is the classic prescription for an inflationary environment.

Over the past six months, both the total and the core version of the CPI have accelerated: consumer price inflation now is running somewhere between 2 and 2.5%. With short-term interest rates pegged at 0.25% or lower, real short-term interest rates are about -2% or worse. There are at least $10 trillion of short-term deposits and securities paying negative real interest rates, which amounts to a wealth transfer of $200 billion or more from the private to the public sector. This weakens the private sector—the source of most of the economy's strength—and strengthens the public sector, which is the sector with the highest propensity to squander scarce resources. It's a prescription for chronic economic weakness. It once made sense given the public's tremendous risk-averseness and the world's huge appetite for money, but with every day that brings news of an improving economy, it makes less and less sense.

Short-term interest rates are still quite low relative to current inflation trends. Holders of 5-yr Treasuries are losing purchasing power at the rate of about 0.5% per year. With inflation at 2%, 5-yr Treasury yields should be closer to 3%, or about double their current level.

Fortunately, it doesn't look like risk markets have become overvalued—yet. But the Fed could well find itself with this problem before too long. For now, credit spreads (see graph above) are not abnormally low, and PE ratios are only modestly above average (see graphs below). But if borrowing costs remain in negative territory—thus encouraging borrowing and leverage—the prices of risk assets could experience significant upside potential that at some point could become vulnerable to a crash. We're not there yet by any stretch, but that is what we need to watch out for.

The first of the above two graphs shows the conventional measure of PE ratios: equity prices divided by 12-mo. trailing earnings. The second uses the Shiller CAPE method: equity prices divided by a 10-yr moving average of earnings. (For a more detailed discussion of equity valuations, see this post from one year ago. Equities are less attractive today than they were then, but valuations do not appear to be stretched or unreasonable, given the exceptionally strong performance of corporate profits since 2009.) PE ratios by both measures are only modestly above their long-term averages.

14 comments:

Well, lots of solid data and economic coverage. Great stuff. Another post I will read several times.

Still, I wonder if "interest rates are low."

There is such a thing as supply and demand, and on the supply side of capital, we do not have global free markets. There is more or less compelled savings in China (a 50 percent savings rate!), and huge sovereign wealth funds where capital is accumulated, and private and public pension funds globally that must by law save. Insurance companies too. Japan has high savings rate, perhaps for cultural reasons.

Then you have a new global super upper class of savers--one example: you think Russian klepto-oligarchs are going to stop stuffing money into London as interest rates are low?

So (as Bain & Co. says) we have a global glut of capital.

In this environment, you "should" see low, even negative interest rates, and losses on savings. That is the market signal at work--unfortunately, that signal does not reach China, Japan, and sovereign wealth funds or even Calpers and Calsters or the LACERA. They keep saving!

Supply and demand--the sword cuts both ways, and now it is cutting against savers.

Savers are outraged, indignant, hostile. They believe they are entitled--but they are entitled to losses as well as gains, in free markets. They also can choose not to save.

The Fed can try to raise rates, but as Milton Friedman pointed out, a central bank cannot tighten its way to higher rates for long. Low rates are a sign of relatively tight monetary policy.

The Fed may tighten, only to see 10-year rates collapse down to 1 percent, ala Japan and Germany. Lower rate, and not higher!

Indeed, with some bad luck I see one percent Treasuries coming, If we have another recession--and this recovery is 60 months old already, longer than the average postwar recovery of 58 months.

A fascinating epoch ahead. Dicey territory.

As for minor inflation in the 2-3 percent range, I think that should be the goal of the Fed, as it is the Reserve Bank of Australia. The RBA appears to putting together a great track record.

We have seen that the degree of monetary tightness it takes to create zero inflation is also the tightness that brings about ZLB and savings gluts. Weak aggregate demand and slack demand for capital.

Zero inflation did not work in Japan, and they gave it a 20-year run. Europe is sinking now, with demand so weak they are approaching ZLB and deflation.

At some point, we have toss out ideologies, dogmas, class warfare, and go with what works.

The Aussies have economic growth with 2-3 percent inflation.

Shouldn't growth be the objective of monetary policy, and not political correctness?

The first 6 months US GDP came in at 1%. (Yes, I know, it was cold this winter...effects of Global Warming).

While many economic numbers are improving, the big one is consumer spending and that one has been weak, thus the weak GDP.

When employment and wages improve, the US economy will be off and running, but the past 5 years plus have not shown this and little has changed. Slack in the workforce reflects an economy strangled by red tape, welfare and cronyism.

Only growth policies can change the 1-2% GDP economy we have, and Washington has little interest in growth policies.

Let the debate continue!!

(As a side note, I do not believe the US Government inflation numbers. I believe it overstates inflation by as much as 1%. Substitution is hard to calculate and more important then ever. The Information Age provides all sorts of substitution possibilities that the incompetent government cannot capture).

Slow steady deflation characterizes a health economy. Productivity improvements result in lower prices. If you believe that the fed can manipulate the price level, I see no reason why the fed should tolerate any inflation at all. A 2% inflation rate means that a man who retires with an adequate pension will die in poverty.

The argument for inflation rests on the assumption that by making real interest rates negative full employment can somehow be restored. Prosperity from making stupid investments. Well, that's what went wrong in 2007. A decade or more of stupid investments followed by a massive expansion of government activity brings us to where we are today - slow growth from a very low base and massive underemployment.

But there is little evidence that the fed can accelerate inflation if it wanted to. The fed no longer controls money if wee define money in an economically meaningful sense.

"(As a side note, I do not believe the US Government inflation numbers. I believe it overstates inflation by as much as 1%. Substitution is hard to calculate and more important then ever. The Information Age provides all sorts of substitution possibilities that the incompetent government cannot capture)."

Congrats---you are one of seven Americans who have an open mind on this topic.

The George Mason U guys (hard core right-wingers) have wondered the same. When Bush was President they said the inflation stats were swollen, and the middle-class was not hurting, as lefties said.

I myself wonder--when I use a smartphone to send full-color pictures transcontinentally in seconds---what is that worth? It would have cost thousands of dollars to do only years ago.

And Craigslist---you can buy anything on Craigslist, which has wiped out the old transaction costs problem of small sales (i.e., the cost of classified ads in newspapers).

Add in dollar stores.

Some areas cost more not due to monetary policy, but due to local land regs.

Take Scott Grannis' neck of the woods. What is causing housing inflation in Orange County? Well, much of the county has been downzoned in recent years. Then, you cannot build skyrise condos anywhere in Newport Beach--in fact, to build a structure with more than 250,00 sf requires approval from the voters of Newport Beach!

All of this tells me is it crazy to peevishly fixate on a nominal index of prices--it may or may not be accurate. It will always be subjective. It will become confused by housing sots.

The purpose of any macroeconomic policy should be prosperity. A policy that says it is only about price stability--if you can measure that---may succeed on some level, but it may also fail to allow prosperity.

Monetary policy should not cosset the (unproductive) retired, or to favor any other group. It has to be focused on prosperity.

BC is certainly right in that technology has lowered the cost of living and concurrently significantly risen the STANDARD of living. this does NOT show up in wages numbers. the bottom line is that EVERYONE across all wage groups is way better off today than they were 20 years ago.inflation is extremely difficult to measure due to this tech phenonmena.

Charles said: "A decade or more of stupid investments {1997 - 2007} followed by a massive expansion of government activity brings us to where we are today - slow growth from a very low base and massive underemployment."

The calculation of inflation is a very important issue, worthy of an article from Scott when time permits.

Imagine putting a price on new eye surgery that saves your sight or new car technology that allow you to avoid a deadly accident. Or a price on real time viewing of grandchildrens pictures..for free!

How effective is the government at capturing this? What about discounts like Groupon, Uber and Priceline? These are not readily published prices.

Despite all the talk of food inflation, Mark Perry's blog has shown were food prices have fallen continuously for 100 years... http://www.aei-ideas.org/2013/09/americans-love-to-complain-about-rising-food-prices-here-are-three-reasons-you-should-stop-whining/

I know oil prices are up (natural gas down), but this is hurting the economy enough to offset any true inflation. I switched from propane to natural gas 7 years ago. How is that for substitution?!? Hope the government captured that one!

Given how low interest rates are, the calculation of inflation is even more critical today.

It is indeed difficult to measure prices when so many are falling, but I do think the government has done a pretty good job. FWIW, the CPI index for personal computers and peripherals has fallen 95% since the end of 1997.

There was a report on Bloomberg concerned that the bullish figure was approaching 50%. Of course those who have followed the AAII sentiment figures know that it goes up and down the performance of the S&P 500. They NEVER lead the S&P in one direction or the other. When the bullish percentage get to 55%, I'll be concerned.

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